Commercial real estate (“CRE”) has long attracted investors for its cash flow, appreciation, and capital preservation advantages.
Unfortunately, very few investors have the expertise or substantial capital to acquire commercial real estate on their own. Fortunately, there are passive investment alternatives investors can turn to enjoy the financial benefits of CRE investment without the steep capital and learning curve required to invest directly.
Two of the most popular choices for CRE investing are:
- Public REITs
- Real Estate Syndications
Investors are attracted to public REITs because of the relatively low barrier to entry (the price of a single share of stock) and because of the requirement that they must payout at least 90 percent of their “taxable income” in the form of dividends to shareholders to avoid federal taxes.
Real estate syndications are private real estate investment funds spearheaded by a “Sponsor” who manages the fund and does all of the legwork, including business formation; deal structure, deal analysis, and asset acquisition; management and disposition, etc.
Sponsors typically contribute their capital and sweat equity into the venture in return for a share of the potential profits. Sponsors usually don’t take a salary and generally only compensated if the fund is successful and profitable.
Profits from a real estate syndication are distributed through a waterfall structure with investors taking the first bite at the apple through a preferred return (a fixed annualized return as a % of profits).
After payment of the preferred return, profits from operations are split between the Sponsor and investors based on predetermined percentages.
Finally, upon the sale of a property, profits are first distributed to investors until they’ve received a return of capital with remaining profits split between the Sponsor and investors.
Investors First
Because of the 90% rule, investors instantly jump to the conclusion that the REITs have investors in their best interest.
However, if they read the fine print, the 90% rule says that the REIT has to distribute 90% of “taxable income,” not 90% of profits. Therein lies one of the significant downsides of REITs: That taxable income can be eaten away by management fees and salaries before any profits get into investor’s hands.
One of the biggest contrasts with private real estate syndication: With public REITs, management gets paid first. With syndications, investors typically get paid first.
One of the glaring problems with public REITs is that management is typically compensated based on assets under management instead of performance.
When management fees and salaries are directly tied to assets under management, management becomes less concerned with the performance of the REIT and more concerned with “empire building” – in other words, attracting investors and growing the size of the assets under management. Management will seek to maximize the size of the portfolios under management rather than the performance of the portfolio assets.
Private real estate syndications, on the other hand, are structured with investors as the priority. Preferred returns ensure that investors get paid first, and that management compensation is directly tied to performance.
An annualized preferred return of 8% of investor capital payable to investors from net profits will motivate management to maximize portfolio performance to get paid.
Putting investors first has resulted in higher returns for investors in real estate syndications vs. REITs.
Based on the NCREIF (National Council of Real Estate Fiduciaries) Property Index, a reliable measure of private commercial real estate fund performance and the NAREIT (National Association of REITs) All Equity REITs Index, a reliable measure of public REIT performance, private real estate funds delivered an average annual return of 6.6% vs. 5.5% for public REITs over the past 20 years.
Besides differences in management compensation structure that make real estate syndications more attractive than public REITs, there are other advantages to this passive investment alternative.
Volatility
Investors are attracted to REITs for their liquidity, but this liquidity is a two-edged sword.
Since public REITs are traded on the public markets, they’re just as prone to wild market swings as any other stock. Because of liquidity and high correlation to the broader markets, public REITs are not immune to extreme market downturns, as we’ve witnessed recently with the COVID-19 chaos.
Private real estate syndications are not prone to the same market fluctuations as their public counterparts.
While the underlying fundamentals of both REITs and syndications remained steady, it was the REIT investors that were taken on a wild ride in the past month with many REITs dropping in value of 30% or more due to the coronavirus panic.
Syndication investors stayed calm and were prepared to ride out the storm. That’s because real estate syndications typically have minimum holding periods of 5-12 years with strict prohibitions on resale. This prevents investor freak outs that are common in the public markets.
By putting the investor first, real estate syndications not only deliver superior returns to their investors vs. their public REIT counterparts, but they do so with less volatility.
Furthermore, because real estate syndications are private and not public companies marred by huge organizations and red tape, their managers are more accessible to the potential investor seeking to align their investment strategies and preferences with a potential fund.
Mike
